Following up on Paul McCulley somewhat disingenous piece we discussed earlier, the Fashion Island bond guys are out with another report, this time by Managing Director Mark Kiesel, who basically is saying it is time to "Sell, Mortimer."
Strong growth in emerging markets (EM), the inventory cycle and accommodative fiscal and monetary policy continue to support the global economy. However, the handoff from the public sector to the private sector in most developed countries is likely to be weak due to a lack of animal spirits exhibited by businesses as well as consumers, high and growing sovereign debt burdens and ongoing deleveraging in the private sector (Chart 1). The U.S. economy’s recent growth has been underpinned significantly by government policy, yet this short-term cyclical support will likely fade in the second half of 2010. As a result, investors should take advantage of the tighter credit spreads and focus on de-risking their portfolios in order to prepare for the increasing long-term secular headwinds stemming from the growing deterioration in public sector balance sheets in many developed economies.
Pimco's distrust of the new normal is nothing new.
Corporate capital spending and hiring remain weak as firms continue to focus on cost cutting, repairing balance sheets and deleveraging. Consumer spending in most developed countries continues to be depressed by weak labor markets, poor income growth, low savings, high debt, the potential for an increasing tax burden and tight credit availability. While prices for low-end U.S. housing have recovered somewhat, most of the improvement has been driven by the government’s homebuyer tax credit. The government’s “cash for clunkers” stimulus program is over, and there appears to be only limited pent-up demand for autos in its absence. Simply put, private sector demand remains weak and public sector support is set to fade.
The biggest threat to capital markets everywhere is the gradual (or sudden) withdrawal of liquidity. On this point Kiesel seems to contradict his superior McCulley in a variety of ways, mainly in that he expects Central Banks to act prudently and rationally.
Further, public sector debt has now increased to a level that will require fiscal tightening in most developed countries. State and local government spending is also likely to be reduced. In addition, monetary policy is likely to become less accommodative globally as central banks unwind unconventional liquidity programs put in place during the crisis and gradually raise interest rates. Nevertheless, central banks in countries with high consumer and growing government debt burdens will likely continue to inflate, leading to steep yield curves, in particular in the U.S. and the U.K. The effectiveness of fiscal and monetary policy should remain limited in these economies due to the continuing deleveraging in the private sector, a weak multiplier effect and constrained bank lending (Chart 3).
As we touched upon a week ago, a rather relevant topic that has been untouched for now, is the increase in equityholder-friendly actions in corporate capital structures, which will ultimately be credit negative.
However, there are a number of risks facing the corporate bond market, including defaults, increasingly shareholder-friendly corporate actions and the potential for rising government and municipal issuance to “crowd out” capital and raise corporate borrowing costs. With U.S. economic growth likely to fade in the second half of 2010 and below-trend economic growth likely in 2011, corporate default rates should be elevated over our secular horizon (Chart 4). This argues for investments that are senior in the capital structure and a focus on bonds in companies with strong asset coverage and low leverage.
Investors also need to be wary of the pendulum swinging from bondholders toward equity holders if rising corporate cash balances are diverted to equity holders through increased dividends or share buybacks (Chart 5). In addition, capital spending could pick up given the divergence between capital expenditures and corporate cash flow (Chart 6). This argues for careful credit selection within industries that have the incentive to maintain bondholder-friendly policies.
The cautious conclusion which leads to the earlier observation that it may be time to get out of credits:
While rising public sector debt levels have not yet led to materially higher interest rates, rising demand for credit in the private sector could lead to higher risk premiums as the global marketplace struggles to support large and growing government financing needs. Finally, governments in some countries may choose to raise corporate tax rates in order to reduce growing sovereign budget deficits. All these risks argue for extraordinary discipline in evaluating credit investments.